The Perils of Chasing Outperformance

Howard Marks, the chairman of Oaktree Capital Management, told investors in one of his regular missives that there should be room in our investing minds for “good enough” returns, a sweet spot of asset appreciation that feels acceptable but not necessarily risky.

“It’s based on the belief that the possibility of more isn’t always better,” Marks wrote in 2009. “There should be a point at which investors decline to take more risk in the pursuit of more return, because they’re satisfied with the return they expect and would rather achieve that with high confidence than try for more at the risk of falling short (or losing money).”

The risk that Marks writes about is chasing performance. Much like playing the lottery “because somebody has to win,” chasing performance is falling victim to the view that getting an edge in the markets is something to strive for, that achieving a return that is slightly superior to the total market is not only possible but absolutely worth the trouble.

The challenge here is what one might call the “Olympic viewpoint” error. What’s the difference between gold and silver, and then silver and bronze? In a sport like swimming, a fraction of a second. And the gap between bronze and the rest of the losing swimmers watching from the stands? About the same.

But investing is not Olympic swimming. The difference between “the best” and “pretty darn good” isn’t really relevant over the course of a long investment horizon. You can make up a lot of ground in compounding, avoiding unnecessary fees, and managing taxes carefully. One bad slip, however, and you will wipe out years of value.

Better than Average

Vanguard Group Founder John Bogle expressed the problem of overconfidence succinctly in an interview with Investment Advisor magazine in May 2010.

“We all think we’re smarter than average, better drivers than average, I’ve observed without factual verification that most people think they’re better lovers than average, and they think they’re better managers, because ‘I can pick good managers,’” Bogle said. “The record is bereft of a single scintilla of evidence that’s an easy thing to do.”

In fact, he continued, new data from the well-known financial economists Eugene F. Fama and Kenneth R. French showed that mutual funds beat the broad market just 3% of the time over long periods.

“The odds are 97% that you’ll do worse than in an index fund,” Bogle said. “So I’d just like to bring common sense, reality and mathematical truth back into the world of investing. And don’t think I’m going to stop trying.”

What does this investor “under” performance look like in the real world? One research firm studies this problem quite closely. Dalbar, in Boston, Mass., does an annual quantitative analysis of investor behavior, trying to illustrate how large the gap is between market returns (what stocks do, all things being equal) and investor returns (what really happens to your money because of your decisions).

Unsurprisingly, we’re really bad at guessing the direction of the market, and over every conceivable time frame, bull market or bear. Dalbar found that the average equity investor underperformed by the S&P 500 by 4.32% over 20 years and the average fixed-income investor underperformed the Barclay’s Aggregate Bond Index by 5.56%. I don’t have to look at your portfolio to tell you that underperformance plus management fees isn’t your best strategy.

Forget About Trading

Did investors beat the benchmarks in some years and lose badly others? Nope. In time frames measured by 1 year, 3 years, 5 years, 10 years and 20 years, we consistently would do better — much better — buying an index fund and forgetting about trading.

In number terms, stock investors over 20 years saw returns of 3.49%, compared to 7.81% for the S&P 500. Bond investors got creamed, turning in a paltry 0.94% vs. 6.50% for the index.

Ten thousand dollars invested at 3.49% and compounding monthly over 20 years will turn into just over double your money ($20,076.94). At the higher rate of 7.81%, you would end up with $47,442.75. Same investment horizon, same investment type, just less trading. When it comes to investing, less turns out to be a heck of a lot more.